Editor's Note: We are pleased to present this special Hedgeye Guest Contributor column by Daniel Lacalle. Mr. Lacalle is CIO of Tressis Gestion and professor of Global Economics at the Instituto de Empresa, UNED and IEB. His books include Life In The Financial Markets (Wiley) and The Energy World Is Flat (Wiley). You can follow him on Twitter at @dlacalle.
By Daniel Lacalle
One of the most dangerous statements we usually hear is that “fundamentals have not changed.” They change. A lot.
If we analyze the global growth expectations of international organizations, the first thing that should concern us is the speed and intensity of downward revisions. In the US, for example, we had an expectation of growth of 3.5% revised to 2% in less than six months. If we look at the revision of the estimates for the fourth quarter of 2015 of the major economies of the world, they were downgraded by 40% in less than twenty days.
Not surprisingly, the IMF and the OECD have cut their expectations for 2016 and 2017 growth already in January. Can they be wrong? Yes, but if we look at history, they have mostly been optimistic, not cautious.
This downgrade process is not over.
China is one of the key reasons. The global economy has geared itself to justify huge investments to serve the expected Chinese growth, ignoring its fragility. China, with an overcapacity of nearly 60% and total debt already exceeding 300% of GDP, has a financial problem that will only be dealt with a large devaluation, many investors expect 40% vs the US dollar over three years, and lower growth . That landing will not be short. An excess of more than a decade is not resolved in a year. This exports deflation to the world, as China devalues and tries to export more, and when the “engine of the world” slows down because it ends an unsustainable model, we are left with the excess in global installed capacity created for that growth mirage. Commodities fall and mining and energy dependent countries suffer.
Consensus economists have overestimated the positive effects of monetary policy and expansionary fiscal measures and ignored the risks. Emergency measures have become perpetual, and the global economy, after eight years of expansionary policies shows three signs which increase fragility.
First, excess liquidity and low interest rates have led to increase total debt by more than $ 57 trillion, led by growth in public debt of 9% per annum, according to the World Bank.
Second, industrial overcapacity has been perpetuated by the refinancing of inefficient and indebted sectors. Governments do not understand the cumulative effect of this overcapacity because they always attribute it to lack of demand, not misallocation of capital. In 2008, there was a problem mainly in developed countries. With the huge expansion plans in emerging markets, overcapacity has accumulated and been transferred to two-thirds of the global economy. Brazil, China, the OPEC countries, and Southeast Asia in 2015 join the developed nations in suffering the consequences of investment in huge white elephant projects of questionable profitability “to boost GDP.”
Third, financial repression has not led to the acceleration of activity from economic agents. Currency wars and manipulation of the amount and price of currencies makes the velocity of money slow down. Because the perception of risk is higher, and solvent credit does not grow, as the average cost of capital is still greater than expected returns, causing debt repayment capacity to shrink in emerging and cyclical sectors below 2007 levels, according to Fitch and Moody’s.
Since 2008, the G7 countries have added almost $ 20 trillion of debt, with nearly seven trillion from expansion of central bank balance sheets to generate only a little over a trillion dollars of nominal GDP, increasing the total consolidated debt of the system to 440% of GDP.
A balance-sheet recession is not solved with more liquidity and incentives to borrow. And it will not be solved with large infrastructure spending and wider deficits spending, as Larry Summers requests.
Offsetting the slowdown from China and emerging markets with public spending is fiscally impossible. We have exceeded the threshold of debt saturation, when an additional unit of debt does not generate a nominal GDP increase. Global needs for infrastructure and education are about 855 billion dollars annually, according to the World Bank. All that extra expense, if carried out, does not make up for even half of the impact of China, even if we assume multipliers that are more than discredited by reality, as seen in studies by Angus Deaton and others.
China is about 16% of global GDP, its slowdown to sustainable growth cannot be compensated with white elephants. It is not pessimism, it is mathematics.
The monetary “laughing gas” only buys time and gives the illusion of growth, but ignores the imbalances it generates. Financial repression encourages reckless short-term borrowing, attacks disposable income and is accompanied by tax increases that affect consumption.
In the United States, following a monetary and fiscal expansion of over $24 trillion, the economy is growing at its slowest pace in three decades, real wages are below 2008 figures and labour force participation is at levels of 1978. Its total debt is nearly 340% of GDP. The economy´s fragility is such that the impact of an insignificant rate hike -from 0% to 0.25% – is phenomenal.
The odds of a recession in the US have tripled in six months. Although I find more plausible a scenario of poor growth, indicators of consumer and industrial activity show a clear weakening.
The capital misallocation created by excess liquidity and zero rates have led to a credit bubble in high yield that issued at the lowest rates in 38 years, masking their true ability to repay. Looking at the figure globally, maturities of corporate and sovereign bonds to 2020 are nearly $20 trillion. Up to 14% of those are considered “non performing”.
With all these elements of fragility, it is normal to assume we face an environment of low growth, but there is reason to doubt a global recession.
The Chinese problem is mostly in local currency and within its financial sector, reducing the risk of contagion to the global financial system.
Dollar reserves in emerging countries have only fallen by 2% in 2015 and remain at record levels.
Although default risks in emerging markets, mining and commodities has risen recently, the total combined fails to reach a fraction of the extent of the real estate bubble risk in 2008.
Additionally, it is unlikely that a global financial meltdown effect will happen when it did not occur in 2015, with the perfect storm of devaluations, falling commodity prices, terrorism, Greece and growing geopolitical risk.
Consumption continues to grow due to the growth in the global middle class and the effect of technology, which provides efficiency and good disinflation.
This is a slowdown from oversupply, not a credit crunch led by financial risk, and as such it puts in question the possibility a global recession. But increased consumption will not compensate for the saturation of the obsolete indebted industrial growth model.
For more than a year I have warned of a long period of weak growth, but we should not confuse it with a global recession. Repeating the mistakes of these past years will not change the landscape. It will perpetuate it.
Negative real rates do not stimulate investment. They slow lending to the real economy and encourage short-term speculation.
The exit from a balance-sheet recession is not going to come from the same mistake of increasing public spending and adding debt. It will only be solved when we recover as main policy objective to increase disposable income of households, not attacking it with financial repression.